Reader Question: Should I Invest in My Non-Matching 401(k)?

Occasionally, Consumerism Commentary readers send in questions about handling their finances. I am not a financial planner, so I have no certification claiming I’m qualified to give financial advice. I am not an investment adviser, so I certainly won’t be recommending stocks. I like the opportunity to address financial questions that other readers may be concerned about, and if I have an opinion or two on the matter, I’d be happy to share.

Readers may disagree with my opinion, or they may agree. Addressing these questions is also an opportunity to instigate discussions. As with any advice you may receive, it’s always good to check with a professional beforehand, particularly if the decision could have significant effects on your financial condition.

Here is a question I received from Steve:

I’m 24 years old and I haven’t started any retirement savings, but I know I need to start. My company offers a 401k benefit but does not offer any match. I was wondering, would this 401k’s tax benefits still be worth taking advantage of over other retirement investment vehicles? Would a Roth IRA be wiser? Or something else?

Taxes are a distant second next to the best benefit of most 401(k) plans: matching contributions from your employer. Employers can structure the matching contributions in a variety of forms. One of the most common is for your employer to match 100% of your contribution up to a certain percent of your salary. For every dollar you take out of your paycheck to invest in your 401(k), your employer might also contribute a dollar of its own money. This is an immediate 100% return, much better than what you can expect from any of your investments. If your employer matches your contributions, find a way — any way — to contribute to your 401(k) at least enough to take advantage of the maximum matching benefit. Don’t turn down free money.

The choice to invest in a 401(k) gets more difficult when there is no matching contribution from your employer. At that point, your 401(k) becomes just another tax-advantaged investment account. Unless your 401(k) gives you access to low-cost investments, this account should no longer be a priority. Most 401(k) plans include fund choices that are not as inexpensive as choices you can find elsewhere, like at Vanguard or Fidelity. Low costs correlate to better investment results over long periods of time, and at age 24, this particular reader could be waiting many decades before accessing this money.

You can compare costs by reading the prospectuses for the investment choices in your 401(k) and comparing the expense ratios and other fees with similar funds managed by Vanguard.

Without an employer match, consider maximizing your IRA before contributing to your 401(k). A traditional IRA offers the same tax benefits as a 401(k), and a Roth IRA forgoes the tax deduction for your contributions today for a tax deduction in retirement. That’s a good choice if you expect that you’re in a lower tax bracket today than you will be in retirement. Considering the economy today, it’s probably a good bet that all taxes will be higher in thirty or forty years as the country struggles to pay its expenses, but you never know without a crystal ball.

While your investment choices in your 401(k) are limited, you can invest in almost anything in your IRA, depending on how you open the account. Your investments in IRAs are subject to an annual limit. If you have a strong enough cash flow to schedule your IRA investments throughout the year to the maximum and still have free cash flow, then you should consider investing what you can in a 401(k) without an employer’s matching contribution if your income isn’t above the maximum for taking advantage of the tax deduction. Otherwise, just invest using a taxable (regular, non-retirement) brokerage account. You can name the account “For Retirement” and leave it alone for forty years.

I wish I had been thinking like Steve when I was 24. I’m not sure I knew about the existence of 401(k) plans when I was that age. My employer didn’t offer a 403(b) plan — the non-profit version of the 401(k) — until the following year or two, and my cash flow was so tight, there was no matching contribution, and the investments were so expensive I just laughed. My only investment was in the form of a recently-converted UTMA or UGMA invested with what was probably savings bonds I received as gifts as a kid.

In reality, just making any choice for investing is better than making no choice. Whether you invest in a 401(k), IRA, or taxable account, just the act of putting money aside for retirement puts you ahead of half of all Americans in taking steps to ensure you have a stronger future.

Do you agree or disagree with the strategy outlined above? Share your thoughts on what you might do if your employer were not to offer a matching contribution on your 401(k).

Agree with your thinking Luke, but my quick answer for your reader would be: Aim to do both! (max out 401k and max out a Roth IRA). If there’s not enough cash to do both, first my advice would be to scrutinize the budget and make every effort to free up more cash for retirement saving. If that doesn’t work, I’d fully fund the Roth IRA first. If the employer begins a matching program, then contributing to the 401k at least enough to take full advantage of the match would be a higher priority than the Roth.

Usually the 401k’s are higher fees and poor investment choices and you can do better on your own with an IRA. Look up your company on Brightscope.com and see if they’re listed there. If the plan is highly rated on Brightscope with low fees then it could be a good choice. My company’s 401k is actually free of fees and has decent index options.

One thing to keep in mind with the IRA vs Roth IRA is that you do want a certain amount of taxable income during retirement. Why? Because you get some tax free income based on standard deduction and exemption. Today a single person can have about $10,000 of income totally tax free or $20,000 for a married couple. So you want some of your income to be taxable to take advantage of that $10-20k tax free income. If you save in an IRA you could pile up $250k as a single person then pull out $10k a year in retirement tax free.

If you happen to currently be in a 0% tax rate then you absolutely want to go with the Roth IRA.

I would go for the Roth. It also gives you the flexibility to be able to withdraw contributions down the line if you get into a pinch. (Hopefully you have the discipline to exercise this option only in a dire emergency). Like Flexo, I don’t imagine that income taxes will ever be able to be reduced. It’s almost impossible to imagine a scenario where they will be cheaper in the future, unless another type of tax is created.

In order to make this decision I think one must know one’s self. Am I self disciplined enough to make IRA contributions outside of an employer retirement plan? Many are not and as a result the best laid plans fall to the wayside. If one has some doubts about his/her self discipline to develop the consistency to invest regularly, then the 401(k) is a better solution in that those dollars will be taken out automatically, before the employee sees them.

401(k)’s have a wide range of decentness. Some large company 401(k)’s beat what you can get in an IRA. The effectively infinite number of choices in an IRA can be paralyzing. (This is not a ding on those who are paralyzed. It’s just human nature and we would all do well to acknowledge our own human nature and work with it instead of trying to fight it.)

One nice factor of our tax code is that you (usually) use a 401(k) AND a Roth IRA. If you can’t afford to do both you probably have a low income and thus low tax rate and should perhaps focus on the Roth. If you have a high tax rate and can’t do both then you simply aren’t saving enough! Just as Kurt said above.

With a non matching 401k I would choose the IRA or Roth IRA and pick where you want to invest and what you want to invest in. Once you max it out though I would start using the tax advantages of the 401k.

Thanks for answering my question Flexo. Also thanks to the people who’ve posted comments. You’ve given me some great stuff to think about and look into. I checked my company’s score on BrightScope and we’re ranked below average.

I was actually going to begin investing in my company’s 401(k) in late 2009 during open enrollment, but that was when they took away the match due to the recession, so I decided not to. It’s time for me to get serious about making this happen.

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About Luke Landes

Luke Landes founded Consumerism Commentary in 2003 and has been building online communities since 1990. Luke has contributed to PC World Magazine, US News, Forbes, and other publications. Read more about Luke and about Consumerism Commentary.

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